The Unchosen One

I have been assigned the task at school to give a presentation on the $700 billion bailout. The more and more research I do, I feel like I’ve been used. What was happening on Wall Street is one of the biggest scams I’ve ever heard of. I have decided to share with you what I have composed so far. I think you will be as shocked as I was.

We here in America are in the largest financial crisis since the Great Depression. In the United States, the economic crisis began when the credit market expanded. The expansion is believed to have begun when the dotcom bubble burst, as well as after September 11, 2001. It is believed these two instances caused the expansion of the credit market because both instances resulted in drastic interest rate cuts. With interest rates being cut, it became cheaper for people to borrow money, and the people did. People borrowed money for cars, shopping and homes. The subprime market grew with the expansion of the credit market.

The expansion was also aided by banks abilities to securitize these mortgages and sell them to government sponsored entities or GSE’s. The GSE’s that bought the majority of these securities were Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac didn’t actually lend money to consumers to buy houses. What they do is they buy mortgages from smaller banks so the smaller banks have money again to lend out to their customers. As banks sold their assets to GSE’s, it freed up money to be lent out. This increased the number of subprime mortgages being issued and then sold to the GSE’s, and the problem grew. Investment and commercial banks established special purpose vehicles, which are financial entities created for a specific purpose. This is probably the biggest scam I have ever heard of. Special purpose vehicles or SPV’s were established to take part in investment activities using assets conferred on them by banks but close enough that the banks could still access the assets if necessary, but they weren’t under the control of the bank. So the banks didn’t have these assets, which would become liabilities, on their books, and these SPV’s didn’t have to disclose them either. These assets were not listed on the entities balance sheet, and it was not publically disclosed as to what the assets were. There was no way to know about these transactions unless you worked on Wall Street or were a Washington insider.

 SPV’s began to package mortgage backed securities with credit card debt, and other debt receivables, and then sold them to investors. Subprime mortgages were chopped up into pieces and spread out into several different packages to spread any risk involved out into many different packages to reduce the overall risk of a single package. These packages were then rated as AAA. A triple A rating is the rating given to government backed securities, essentially rating them risk free. These packages yielded high returns with what seemed to be no risk involved. These higher yields attracted many investors. Many of these packages were traded around bank to bank, freeing up money as one package was sold to another bank.

These packages that yielded these high returns were also over-priced, and over-rated. These packages were given a risk free rating, and were priced as if home prices would continue to rise. Wall Street demanded more securities to sell so they could get richer. The banks complied and made riskier loans. They increased the subprime market again. Spme in Washington were aware of the problem and tried to warn of the problems to come. Nobody acted, and Washington supported the further deregulation of the banking industry. This is where the story turns south. Starting in 2006 the rate of delinquencies for mortgage payments increased. If homeowners fincanced their home purchase with an ARM they saw their monthly payment sharply increase. Many homeowners were defaulting on their loans, and many of these loans were subprime loans. The market demand for homes began to shrink, and this led to a surplus of homes available for sale. The market reacted naturally, and home prices dropped with the excess supply.

In 2007 these packages were re-evaluated and re-rated. The ratings of these packages dropped from AAA to A+. With the drop in the ratings, and the decline in home value, the prices for these packages also dropped. Many banks that purchased these securities had funded the purchases of the packages by issuing commercial paper. Investors became less and less willing to purchase this commercial paper, and banks could not obtain short term funding. With it becoming harder to obtain funding many banks stopped lending to other banks. Banks began revealing their losses and writing off these packages that were purchased that turned out to be nearly worthless. This led to a continued hoarding of money by banks. They felt that if they lent to other banks, those banks might also have unrevealed losses and might not be able to pay back borrowed money. Banks also did not lend money for the fear that they may need it to cover any losses they may have. This essentially froze up the credit market.

The Federal Reserve began lending money to hurting banks. The Fed extended the length of the period for which it lent money to banks in order to help free up money that could be lent out. This solution did not work as well as hoped and banks began failing. The banks weren’t lending still, rather they were investing in government backed securities. The biggest news came with Indy Mac failing. The next big news came with Fannie Mae and Freddie Mac being in trouble. The government stepped in and took over Fannie and Freddie. With the fear of a collapse of our economy the government proposed the Emergency Economic Stabilization Act.

 The Emergency Economic Stabilization Act, also known as the bailout bill, was passed by Congress to help alleviate the problems of liquidity in our economy. It has given our government the authority to spend up to $700 billion dollars to purchase distressed assets from banks. This is supposed to be a comprehensive plan that will boost investor confidence, improve liquidity, and work in a broad and quick manner to help stabilize our economy. The plan is to also provide more oversight and regulations to the industry.

Most people were and are against the bailout and were pressuring politicians to vote against the bill. The first attempt to pass the bill failed. In an effort to gather support for the bill, George Bush went on television to tell America that we were facing the largest financial crisis since the Great Depression. He told the American people that we could end up in the Next Great Depression should the bill never pass. He did gather support but Americans demanded that the people responsible for the crisis not be rewarded on their way out. The bill eventually passed after much debate, and we wait to see what effect if any the bill will have on our economy.

I use to be a proud supporter of the bill, but now regret having those feelings. While I like the fact that Congress has worked to help the economy, this is also going to benefit the criminals on Wall Street, and in Washington that caused this mess. As much as I don’t want to see these crooks get bailed out, there is no other alternative that seems feasible given the situation.

http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf

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